When I was new to investing, I used to base most of my decision making on historical share price performance. If a stock had jumped in value, I’d buy it. If it was falling, I’d ignore it. This momentum-based style of investing wasn’t necessarily wrong. However, I now make use of a host of different indicators to help me find gems in the stock market. Here are some of my favourites at the moment.
Low debt ratio
The debt ratio simply looks at whether a business has more debt than assets, or vice versa. A figure above 100% is bad, as it suggests that the company has more debt than assets. The problem with this at the moment is that rising interest rates are making debt more expensive. To take out more loans, the interest expense is going to be high.
In another way, a high ratio isn’t good at a time when the global economy is slowing down. If there was ever a time to have little debt on the balance sheet, now is it!
Therefore, to find good opportunities, I’m looking for stocks that have manageable or low ratios. For example, Shell currently has a low debt ratio of 43.46%. I don’t have concerns here that the business will struggle with that, which makes it attractive to me to consider buying.
Good cash flow and liquidity
This might sound like a boring point to focus on. However, I think it’s a real differentiator between average and great stocks at the moment.
One measure I can look at is the current ratio. This simply divides the current assets by the current liabilities. A figure above one shows that the business has enough short-term assets for liquidity to cover any expected liabilities. If the figure is dipping below one, it should start to ring alarm bells. In the tough trading environment, I don’t want to be stuck owning a stock that has cash flow problems.
Different sectors do have different standards, so I need to be careful when comparing ratios between different areas. But let’s take pharmaceuticals as an example. GSK has a current ratio bang on one. As for AstraZeneca, the ratio is 1.38. This might not seem significant, but it can make a large difference when we’re talking about many millions of pounds.
I call this discovery a hidden gem because most investors wouldn’t note that GSK could be tight on managing cash flow. I’m not claiming that this is going to be a real problem for the business. But if I want to buy a big pharma stock, AstraZeneca would be my safer option.
Doing my homework on the stock market
I try and do my research on a variety of areas before making a decision on what to buy. If I can find a stock with a low debt ratio, a good current ratio and other green lights, I’m in business. Of course, I can’t just use one indicator in isolation. But by knowing what I’m looking for, I can hopefully avoid costly mistakes.